March 9th, 2011

Top Capital Management Stories on GC Capital Ideas

Posted at 1:00 AM ET

Here we present our most popular stories from GC Capital Ideas focusing on Capital management.

Lloyd’s Market: New Year, New Strategy  The new year follows a challenging renewal season for the bellwether Lloyd’s Market, which, despite losses incurred during 2010, showed that rates continued to soften. Lloyd’s enters 2011 focused on its new market-level strategy plans and preparation for Solvency II, now less than two years away from implementation.

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Domiciles: Reinsurers Look to Europe:   Since 2005, a notable shift in reinsurers’ domiciles has taken place. Europe’s transition towards risk-based capital requirements has prompted global regulators to call for some level of equivalence in key markets. This has, in turn, prompted carriers to reassess corporate structures, with a particular eye to the location of group balance sheets.

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Regulatory Activity Remains a Central Focus, Part I: Solvency II: a Global Issue:   We enter 2011 with forces at work that are poised to reshape the global reinsurance industry. While the largest of them - Europe’s Solvency II regulatory framework - will not become fully effective until 2013, preparations for its sweeping changes will be an important agenda item for many firms in the year ahead.

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Potential Catalysts for a Cycle Turn, Part I: Given low valuations, low yields, macroeconomic instability, inflationary pressures and lower pricing, it is not unreasonable to argue that the current operating environment is among the most challenging in living memory. The question most frequently posed in the reinsurance sector currently is: What will it take to turn the market? Below we discuss several potential scenarios that could expedite the turn. However, it is most likely that a combination of events will ultimately create the inflection point from which the sector will again enter a hard market.

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The Low Valuation Trap, Part I:  Another effect of the sector’s growing capital position has been a marked decline in reinsurers’ valuations. The price to book ratio of the Guy Carpenter Global Reinsurance Composite is near twenty-year lows, or over two standard deviations below the long-term mean, at 0.91x. These low valuations have significant implications for reinsurance company managements with regard to company strategy and capital budgeting. They are also important considerations for financial flexibility and the potential for sector consolidation. Figure 4 plots the price to book ratio of the reinsurance sector from 1990 to the present day. The drop-off in the last decade has coincided with higher loss activity, falling interest rates, increased capital requirements and lackluster equity global valuations generally.

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Preparing for an Inflection Point:  The macroeconomic environment as we enter 2011 is a challenging one for the reinsurance industry. A combination of low yields, high levels of sector capital and lower rates on-line has led to a climate of persistent low valuations and stubbornly suppressed forward earnings rates. In addition, there is no clear catalyst on the horizon. Until we see a meaningful change in one of these underlying factors, the forecast is for more of the same.

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Turn Insurance Portfolio Modeling and Management into a Strategic Advantage:  Companies that optimize the use of economic capital models to holistically manage portfolios may gain a powerful advantage in the marketplace. Improved risk decision-making and capital allocation can translate to profitable growth and an increase in shareholder value. But, it takes a commitment: ongoing integration and evaluation of the models in the operation may create ongoing benefits to results.

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Reinsurance: An Efficient Source of Contingent Capital and Risk Protection:   Insurers today are faced with challenges including lower pricing, long-term low interest rates and diminishing reserve redundancies, not to mention increasing natural catastrophe activity in peak risk zones such as Florida. Effective capital allocation and earnings protection are crucial to ensuring profitability and financial flexibility in this environment. The reinsurance purchasing decision is an integral aspect of both risk and capital management. In terms of risk, reinsurance protects insurers against peak or ‘extreme’ events, enabling them to continue providing cover in the wake of disasters. In terms of capital management, reinsurance is an efficient source of contingent capital that allows carriers to enter new business lines, satisfy changing regulatory requirements or simply maintain creditworthiness.

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